What you think is a good investment because of what you see and hear is seldom a good investment. A good investment is usually the one you don’t hear much about. Or if you do, you only hear disgust and shame.
Because when an investment feels disgusting to own, its perceived risk is higher and because of that, the availability of capital (money) flowing into that investment gets scarcer. It becomes an undercapitalized situation. No one wants to buy into its stock or bond unless they are heavily discounted.
To attract capital, that investment needs to then offer a better rate of return. Think of Google versus the Ford Motor company. Everyone would agree that Google is a better company than Ford. It has higher earnings, higher return on equity and a much faster growth of earnings so the question is what do you know that the market doesn’t already know.
The market hence has set the valuation accordingly. That is the reason the stock of Google trades at 40 times earnings and Ford Motors at 7. The fact that Google is a better company, that is information but not value-added information because everyone knows it. It is factored into the PE ratio.
What sets stock prices is the expected growth in earnings and the discount rate used to discount those future earnings. If perceived risk is higher for a given stock, its discount rate is higher. Ford is a riskier stock to invest in than the stock of Google. The market has already decided that.
And a higher discount rate means a lower value for a given stock since the discount rate is in the denominator in a stock valuation equation. That is why Google stock trades at a premium valuation (lower discount rate) whereas the Ford Motor company stock can be had at bargain prices (higher discount rate).
But from the risk-adjusted return perspective, both investments are the same. The market has made them the same. What that means is that you’ll demand a much higher return from owning Ford Motor stock than the stock of Google. The future then decides if the returns you expected turn into the realized ones.
Risk is about the range of expected future outcomes. Bank CDs are the safest. Bonds are riskier. Stock investments are the riskiest. The venture capital bar is added for completeness sake but is not considered investable unless you are running a pension fund or an endowment.
Bull markets in stocks see returns on the higher side of the average (green line) and bear markets on the lower. And when a hot new theme like artificial intelligence comes around, stock prices in that corner of the market get elevated. Everyone wants to buy into that theme because it is perceived as a guaranteed money-maker. It then quickly becomes an overcapitalized situation.
Richard Bernstein of Richard Bernstein Advisors describes this as being in a town with a thousand banks and one borrower. When you are the only borrower and you have all these banks competing for your business, you are going to set the interest rates. And you are going to set them to be as low as possible because you can. Your cost of capital then is low and if you can use that capital wisely by deploying it into your business, you make out like a bandit.
Turn it around and now say you are the only banker in a town with a thousand borrowers. You are going to mint it because you get to set the interest rate on each and every loan. And you are going to set them as high as the market can clear.
So, when it comes to the hottest themes of the day, it is hard to argue that they are starved for capital. There are a thousand banks flooding the market with capital to literally give it away to them.
And it is simple supply and demand of capital that sets the long-term return on an investment. So, if you want to score big or if you don’t want to be left holding the bag, you want to look for situations not many want to invest in.
The question you should be asking hence is that everyone knows about artificial intelligence. It is going to change the economy. And quite a lot of that and more is likely already priced in.
Where is that opportunity then where you get to be that one banker against a thousand borrowers? That is likely staring at you in some corner of your plan and that is where you’d want to consider investing in.
Thank you for your time.
Cover image credit – Jplenio, Pexels